True to form, the White House set forth a sketchy program to limit the proprietary trading activities of banks, and it is a vote for the status quo which is being tarted up as something else. I’m amazed that someone of Volcker’s stature is allowing himself to serve as the branding for ideas that are sound on a high-concept level, but are being gutted in implementation.

The press reports have been suitably vague, but two ideas appear to be central, and they were confirmed by a press background briefing that a kind correspondent sent me. They serve to neuter this supposed reform (I am beginning to think we need to ban the use of the word “reform”; Team Obama has absconded with it. For them “reform” = “anything we do here that sounds important enough that a Cabinet member could talk about it for five minutes”. If they keep this up long enough, which they seem determined to do, the term will be utterly useless.)

You can drive a supertanker though the loopholes in this proposal, which are:

1. If a firm does not own a bank, it can do proprietary trading

2. Trades with customers are not proprietary trades

These are so silly that I’m astonished anyone is treating this proposal seriously.

Let’s dispatch them in order.

Whoever thinks that proprietary trading is just swell as long as the firm does not own a bank (meaning the kind that takes deposits) must have slept through the entire credit crisis (note I am not saying prop trading cause the crisis, but I guarantee there will still be reader who demonstrate in comments that reading comprehension is not one of their strong suits).

The implicit idea is that government backstops extend just to deposit-taking firms. That is patently ridiculous and is an attempt to hide from the public the reality of how the financial system works.

Thanks to thirty years of deregulation, a very large portion of credit intermediation (finance speak for the process of providing loans) has shifted from banks to the capital markets. As most readers know, many types of loans are originated by a bank, combined with other loans, turned into bonds, and sold to investors.

For reasons too long to go into now, bonds are traded over the counter (this is not a nefarious plot; there are legitimate reasons why). Over the counter markets have economies of scale, and in particular, network effects. So trading of credit market instruments, over, time, is dominated by a comparatively small number of very large firms.

Credit is critical to the functioning of any economy beyond the barter stage. As economic activity became larger in scope and scale, and banks increasingly became the dominant credit providers, bank panics became a serious threat, and so various safety nets have been deployed under traditional banks, the biggest being deposit insurance and access to the central bank discount window. The quid pro quo was that banks were subject to strict limits on their activities and intrusive supervision. But those were eroded over time while the safety nets, if anything, became more extensive (consider unofficial support activities, such as Greenspan engineering a steep yield curve after the savings and loan crisis).

But now we have a world in which the credit markets are crucial to modern commerce, more so than banks. It would not be all that hard to break up the traditional commercial banking operations of Bank of America up. By contrast, once you get past hiving off non-capital-markets operations like asset management and commodities trading, it would be much more difficult to break up Goldman Sachs. And perhaps more important, absent regulation, it would tend to re-evolve back into its old format. A set of oligopolies, with information synergies among them to boot, is an extremely attractive business proposition.

So any capital markets player of reasonable heft WILL be backstopped. That was the big lesson of the crisis just past and is not lost on the industry incumbents. Does anyone with an operating brain cell believe that if BofA divested Merrill and Merrill hit the wall again that it would be allowed to collapse? Look, we have twice had rescues of major non-banks, first LTCM, then AIG, due to the impact their failures would have ON CAPITAL MARKETS, not on depositors!

But the second one is even more of an insult to the intelligence, that proprietary trades and customer trades exist in neat, tidy boxes and a trade with a customer is therefore a pure act of mere passive order taking. When Goldman went net short subprime, was that not a proprietary position? And who do you think was on the other side of that trade? Hint: for the most part, not other dealers.

Why do you think institutional salesmen entertain clients so lavishly? Read Tetsuya Ishikawa’s How I Caused the Credit Crunch and find out how CDOs were sold.

When a firm has a big position it needs to unload because it see market conditions change and it needs to change course, it will push it out to investors. The idea that putting on and unwinding prop trades takes place only with other dealers (which is what this is effectively saying) is bizarre.

Reader Michael C did an excellent job of dispatching this notion yesterday in comments:

What is Prop Trading?

That’s an easy question to answer.

Any position that ends up in the Var exposure is prop trading.

Var measures exposure to market risk. Var is the measure of market risk used to determine the amount of capital required to support the trading activities at banks under the BIS capital framework. There is no uncertainty about what constitutes trading risk (prop trading) . Indeed, the market risk capital requirements were designed to enable the prop desks at banks the flexibility to manage the market risks of their prop activities free of regulatory interference regarding the component pieces, provided they held capital against the books.

Market Risk exposure (which includes credit risk translated into market risk through capital market and derivative activities (i.e CDO and CDS)) arises through the trading activities of the institution.

The “who can tell what’s customer driven and what’s prop trading “ argument is completely bogus. If the activity leaves the institution with net market risk exposure, that activity is prop trading. I believe this is Volcker’s view.

To determine what is appropriate prop trading for an institution, review the Var exposure by trading desk at each institution, then determine which prop trading desk rightfully belongs in a federally backstopped institution. To be precise, review the positions feeding the Var. The risk calculation methodology issues are irrelevant for this argument.

For example, if the structured products desk at GS generates market risk and thus Var, and if it’s a major profit center, GS needs to convince us that this is an activity that should be supported by any type of govt support…

GS’s defense that the prop trading represents a sizeable but small % of their revenues is nonsense. They may make the lions share of their trading profits on transaction spreads, but the additional % they designate as prop trading on the residual exposure is a piece of the whole trading activity that is considered as “prop’ trading under the global banking standards.

I’m exasperated by the press coverage, especially in the NYT and WaPo which seems to be perpetuating the myth that the bankers are just too clever and any attempt to regulate is guaranteed to be gutted and dead on arrival.

Bullshit. Your recent reporting is a clear sign that that mythology has lost its power to mesmerize.

So let us be clear: the “bankers are too clever” meme is a very convenient cover for the fact that the government is in bed with the plutocrats.

Clusterstock tells us how little impact the prop trading proposal will have (and it ran the very day the new proposals were announced):

Big banks have already begun poking the holes in Obama’s new rules—holes they expect their banks to pass through basically unchanged.

The president promised this morning to work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

But sources at three banks tell us that they are already finding ways to own, investment in and sponsor hedge funds and private equity funds. Even prop trading seems safe.

A person familiar with the operations of one big Wall Street bank said it expects that new regulation will affect less than 1% of its overall business.

And that’s before Congress waters the legislation down further. So much for change you can believe in….

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Yup, after it taking literally hours for “size limits reform” to be revealed as a fraud, it only took a day or two to debunk the “prop trading reform” fraud (though the utter vagueness of the thing, too vague to even be called a proposal, gave it away as well).

There’s no reason prop trading should be allowed to legally exist at all. Let the derelicts gamble in sleazy back rooms in broken-down dives where they used to. That’s the only real reform for this.

I agree on the troubled terminology of reform. My practice is to call anything like this “reform” in the quotation marks to signify its fraudulence and the Orwellian use of the term.

Meanwhile I have to use terms like real reform or real reformers to signify what would be real reform if enacted. (Usually the term “revolution” sounds too melodramatic for now, but real reform is really a synonym by now, since we’ll definitely not get real reform for as long as the system can stay zombified.)

Yves asks: “Does anyone with an operating brain cell believe that if BofA divested Merrill and Merrill hit the wall again that it would be allowed to collapse?”

The libertarians and their Austrian-Neoliberal clones do. Of course libertarians don’t live in the world that is, but in the world that ought to be, or as Reinhold Niebuhr put it, in their “paradise of innocence.”

“Whoever thinks that proprietary trading is just swell as long as the firm does not own a bank (meaning the kind that takes deposits) must have slept through the entire credit crisis.” The architects of this scam-reg proposal—Emanuel and Summers we may be sure—don’t have the slightest interest in substantive reform, so the actual connection of prop trading to the ‘bank panic’ is immaterial to their machinations. The function of this proposal is to pat Dick and Jane Prole on their gray and pointy little steaming heads and say, “Rest assured, folks, them bankers won’t be allowed to speculate with yeeerrrrrr savings—as long as you keep voting for us.” The thing is just ‘for show;’ they probably had this tawdry, deceptive farce of a proposal up their sleeves just against the possibility the poll numbers went bad. And boy, did they. Think back; we’ve had a whole series of fake reform proposals and phony government ‘interventions’: that is the M.O of Barack’s Boys. If you’ve paid any attention to Emanuel, you know this is his approach, the guy knows he’s too smart for the schmucks whose votes he’s hustling so he continually insults their intelligence, not believing that said quantity exists—and he’s failed with his electioneering time and time again just for that reason. Summers definitely thinks he’s twice as smart as the next person on the planet so no worry that anyone will catch him marking cards, writing the wrong score on his golf chits, and pocketing invoices as he walks right past the cash register out the door.

Folks, Emanuel and Summers run this policy shop; don’t think Obama thinks for himself. I hope we can get past notions that Paul Volcker will be allowed to get within shadow-casting distance of actual policy direction. Never happen with those two giant egos around, Paul’s in the ‘photo op’ just for the political capital they can pick from his pockets, during the election campaign, during the first head fakes to Congress, now with the hustings going black and tarry. Oh, I don’t expect that Emanuel, Summers, Geithner, and their like will hang around to the bitter end. Somewhere in the back half of 2011 some or all of them will ‘leave to pursue other opportunities,’ jumping the sinking ship having destroyed any chance for reform before the position of their nominal faction of the One Party Uber Alles craters. I doubt that they’ll be fired in time for it to do any good, or fired at all; that would imply that their tenure had been one of failure and hence that their appointment had been a mistake. Obama is clinging to the rotting fish head which is Ben Bernanke exactly for that reason, so as not to admit to having made a mistake in backing him. The mistake matters far less in political calculation than to the admission of failure—which is why failure speads like oil on water in this Administration and the last one; denial is like an exponentiator for any problem to which it is applied.

This kind of crapola is all we are _ever_ going to see out of Bo Prez and his henchmen during the three years we have left before he drags his sorry ass out of the District with ‘exit polls’ near the numbers of his predecessor; domestic polls, he’ll hold up internationally just for not being George Idjit. But at that point, both of faces of the one-party system will have amply demonstrated their inability to govern honestly or competently, no enviable position for the country. The Repubs are despicible; the Demoblicans are contemptible; the Greens are invisible; the rest are risable. What’s a body to do? Get to work on change ones own self, with ones neighbors and friends and like-minded others. Trusting bought-and-paid-for factions to do it for us is what got us where we are today: looking up at a toilet seat vanishing to the other end of a tube in the ground.

Neoclassical economic theory and non-cooperative game theory have usually assumed that rational egoists are the only type of player that scholars need to assume in order to generate useful and validated predictions about behavior.

And, as they go on to explain, this has resulted in

A considerable body of contemporary policy analysis [being]…based on the earlier widely accepted presumption that all individuals are strictly rational egoists motivated entirely by external payoffs.

The end result of embracing the religion of greed and selfishness is that our politicians can telegraph to the citizens, as Gintis et al put it, “two rather devastating messages in regard to the long-term development and sustenance of a democratic society”:

1) ….only short-term selfish actions are expected from “the common people,” and

2) …citizens do not have the knowledge or skills needed to design appropriate institutions to overcome collective-action problems.

And as they go on to explain:

The two implicit messages contained in much of contemporary public policy analysis are not only inefficient and ineffective, they are dangerous for the long-term sustainability of democratic systems of governance. The first message undermines the normative foundations of a free society. It basically says that it is okay to be narrowly self-interested and to wait for externally imposed inducements or sanctions before voluntarily contributing to collective action. The second message undermines the positive foundations of a free society by destroying the capacity of citizens to experiment with diverse ways of coping with multiple problems and to learn from this experimentation over time. This message basically says that there is one best way of solving all collective-action problems and it is only knowable by experts. Citizens are viewed as having little to contribute to the design of public policies.

I’m disgusted. I’m not surprised, but I am disgusted. There is the tragedy of the past 30 years of wasting past crises by gutting laws passed when people suffered — then there is the tragedy of not only wasting the present crisis, but actively working to SUCKER the public into thinking that something is being done on their behalf.

Yves, this is off topic. Did AIG FP insure synthetic CDOs held by pensions? If pension funds around the world were stuffed with casino chips, and only the US government were keeping AIG standing, I would want that quiet for a few years as the contracts expired. I would also be sure to keep housing prices up, lest the ABX fall,triggering collateral payoffs.

As to the theme here, I see no problem with the segregation of trading desks from ‘banking’ institutions. That is a model we need to reinstate.

As to trading desks in general. In the transaction itself, the counterparty is generally indifferent as to whether the trader is acting as principal or agent. Now when the trade is very large, the principal/agent question becomes very important. Similarly, sequential trades that aggregate to a substantial percentage of outstanding shares are an important information piece.

This gets to an important part of this problem. If the bank is acting as agent on behalf of a true third party, not a subsidiary or bank sponsored entity, the bank is not trading on OPM. Now, as I understand the word propriety, that means in one’s self interest. A clearer description might be to proscribe trading as principal. Now that has its own problems. When a bank is trading in Treasury instruments, it is generally doing so with deposit monies; i.e., OPM.

Glass-Steagell dealt with this rather well. Why not go back to what worked so well for so long?

Just to be clear about this, Lehman had a “prop desk,” which looked and smelt like a regular hedge fund, and was properly segregated from desks that took customer orders. GS, MER, C, JPM et al had similar desks. And, yes, these desks have no business existing in gov’t backstopped institutions.

But these desks have never been particularly big or profitable (Barclays got rid of the Lehman desk last summer), and they represented only a tiny percentage of the total proprietary trading done by the banks.

Most of the activity (and all the truly risky activity) took place on the trading desks themselves, where firms maintained separate “front books” for facilitation of customer orders and “back books” for pure prop positions. Both books held risk, but the front book risk was positioned originally entered to fulfill a customer position and, presumably, meant to be unwound as soon as practicable.

While the firms & their apologists will say that losses in the back books weren’t “that” big, and may have only amounted to 10% or 20% of the capital at risk…note that the size of the balance sheets of these firms was roughly 30x the capital base, so even “small” losses, on the order of 10% to 20% of what was at risk would have been MORE THAN ENOUGH to demolish the entire capital base of the institution in question.

A Third Party Emerges In The United States- When Obama’s first and last term ended the American public was fed up with anything that had to do with the elite- Wall Street, the big banks, Congress, the Senate, the Federal Reserve and both of the big parties. As a result a third party emerged which managed to get a large amount of seats in both houses. The party’s candidate for president got 25% of the votes in 2012 and won the election in 2016. The third party fundamentally changed the way politics is done in Washington and resulted in a large change in United States foreign policy. A lot of countries where left to deal with their problems alone. At the beginning, this policy caused havoc and even chaos in different countries around the world which suddenly where shocked by the shortage of American financial and military aid.http://israelfinancialexpert.blogspot.com/2010/01/11-big-surprises-for-next-decade.html

Sad to say, but as much as people had hope for Volcker, early in this systemic crisis, he has proved to be feeble and pointless for the cause at hand.

Also see: “We haven’t just gone through a business cycle, we’ve also gone through a major restructuring of the American economy,” says Ken Goldstein, a labor economist at the Conference Board. “The workout from all of this will be very long and very slow. This is an awful lot to adjust to.”

Um…do any of you guys have any constructive suggestions on how to properly limit prop trading, or even in terms of general regulation of banks rather than whining all day long about Obama/Summers and working to break down everything?

And Yves, it’s funny that you cite Clusterstock at one moment, while the majority of their coverage of the new prop trading rule is extremely negative because they say it WILL effect the banks severely. So…you really are telling me that banks are spending millions lobbying against these rules while they actually believe they won’t be affected at all? Now that’s not sound business.

Are you serious? Fighting potential regulation is done on several fronts. What you want people to know, first and foremost, is that passing any level of regulation against you, of any kind, is going to be long, painful, and costly because you will fight at every level.

The multi-front is necessary because the process is complex, with multiple inflection points. You never really KNOW that it isn’t going to impact your business until the bill is done, through both houses, and signed. Do you really believe that a heavily regulated industry is going to let that process go off without their boots on the ground from the very start?

Let’s just say that I haven’t always worked on the side of God and the angels, and while I don’t know a lot about finance, I do know a little something about fighting regulation. There are many reasons to fight new regulations besides “it’s actually going to impact my business.” And worse – business does many, many things that do not contribute to shareholder value. Having the lobbying tail wag the dog is hardly the most surprising of those.

The banks will continue to induce volatility, because chaos makes them money; Goldman recently defended their position as middle-man for hedging casino bets — thus does anyone think that Obama has the balls or influence to shut down his mafia buddies?

Also see shit like: “Empirically, twelve years of daily New York Stock Exchange (NYSE) intermediary data reveal economically large price pressures and associated social costs. A $100,000 inventory shock causes an average price pressure of 0.28% and the average transitory volatility in daily stock returns (average price pressure) is 0.49% with substantially larger price pressure eﬀects in smaller stocks. The aggregate lost hedging gains are estimated to be $60 billion for all NYSE common stocks for our sample period.”

Also grab your gold-plated Ankle Bracelets and prepare to adjust your gamma (jumpiness) and phi (correlation) parameters, because your root-mean-square error, is about to be adjusted with the same gaussian copula that got us in this f*cking systemic meltdown (run by our fascist government/mafia).

“The poll by The Washington Post, the Henry J. Kaiser Family Foundation and Harvard University’s School of Public Health underscores how significantly voter anger has turned toward Democrats in Washington and how dramatically the political landscape has shifted during President Obama’s first year in office.”

“Nearly two-thirds of Brown’s supporters say their vote was intended at least in part to express opposition to the Democratic agenda in Washington …”

> Does anyone know when the election is, because I know for a fact that Obama is going to be voted out by a landslide, as will every Democrat across America, and it’s not because Republicans are in any way honest, trustworthy or good Americans, they simply represent “change” and Americans are F’ing pissed off at all politico retards, so add that to your economic recovery and the decay of America (which is due to our highly corrupted fascist/mafia government ….

When are people going to figure out that the Obama admin has no and never has had any intention to reform anything that will hurt the large banks or insurance companies?

We elected somone whose skin color was very different but whose actions and policies are much more like George Bush than Franklin Roosevelt.

This is circus and meant to keep the progressives, tea partiers and scott browners thinking that the have more differences than commonalities. The Obama has a huge majority in the House and a filibuster-proof majority in the Senate for over a year and what reforms were passed? Zip, none, nada and bupkus.

Given the facts at this point there are only two possible conclusions: Either the Obama administration is totally and completely incompetent or is as much bought and paid for by the big banks as any prior admin. At the end of the day, are you going to beleive what Obama says or what he does?

I think what they are trying to do is get rid of the very blatant “hedge fund within a bank” type prop desk — many of which have already been eliminated, but will surely creep back over time as markets improve. The mere fact of not allowing a bank to have such an arrangement will reduce risk. Banks will be able shift risk to customer-faced desks, no doubt, but I don’t think it will be at a 1:1 ratio. The regulators can use a number of strategies to evaluate risk on the customer facing desks and set limits at any threshold they choose. We all know that human nature will likely take hold and 10 years from now when times are better, there will be more risk allowed — avoiding that is more a social question than a regulatory one.

As an aside:
Some people do have a problem with having too much risk on the trading desks that actually trade with customers. These desks in my view must use bank capital in order to carry inventory and so carry risk inherently. Limits on inventory may be acceptable, but a straight ban on carrying any securities on the desk does not seem reasonable. More difficult is the problem of traders on these desks taking positions not for the purpose of inventory — some of that may be healthy, but the argument can be made it should be restricted.

Obama campaigned on “hope,” which was an efficacious marketing tactic except that –along with “change”- it planted the seed of a promise for a social transformation. Instead he’s revealed himself to be not a transformative leader, but a transitional figure. Hope meant taking on power, not putting on the people. From the ecological viewpoint, he is no more self-aware than yeast in a wine vat. Ironically, he is not an agent of “change” but resisting release and renewal -creative destruction- and thereby bringing on collapse.

Ok, while its kind of obvious that Obama’s sudden “change of heart” on strict financial reform has a Casablanca air to it “I’m Shocked! Shocked to find gambling is going on in here”!, i dont think that it his proposal (vague as it is today) is wrong. What i mean by that is if its taken as part of a broader financial reform, this might work. As a former industry insider let me try and shed some light.

1) Prop Trading: First your example of building a position and then famring it out to the clients would not happen anymore. You cant build a position first, you must realize a position through a client trade. Now if things stay as they are now this will be problematic. Why? Cause a client trade should be handled (unless it is a large trade relative to the market) by the market-making desk. These trader currently have set exposure limits and are not expected to carry a position for more than a day or two. This is entirely implementable in liquid exchange traded markets as the trade can cover his exact exposure.

The problem is with derivatives and other products that are not exchanged traded. These need to be covered OTC. This would be an impossible situtation for market makers as they cant offset by going to another bank since bank-to-bank would not be considered a client trade.

So this gets to the point that this proposal on its own, cant be implemented without severely restricting the products that a bank can offer its client base. Now if OTC derivatives get hauled onto an Exchange and products that dont make it are prohibited or limited. Then in principal this rule would do well to attempt a new way to separate govt guaranteed institutions taking risky behavior with cheap money.

2) Too big to Fail is your other point and it is valid. Obama did say that size limits would be placed on all institutions that present or could present a systemic risk. This too me is too draconian and would be unnecessary for deposit based institutions if appropriate capital requirements were met and kept. Risk taking institutions should be limited. But our banks do need to compete globally and hence have a large international deposit base.

3) Also critical to making this work, is stopping all the off balance sheet shenanigans. That way their is capital for every liability off or on balance sheet.

4) Credit..credit…credit. This is a Credit Crisis, and we are still far away from dealing with the credit risks. COunterparty risks, such as Lehman, AIG, Merril were being greatly ignored and created massive intermarket exposure on products that we not truly fungible, let alone legally understood or easily so. It is assumed that bank to bank trading can only be done in opening or closing client exposures. that means both banks must be on opposite sides for client purposes. Again this is truly problematic for no standardized products and OTC. We must push for simplification in legal terms and standardization in genral on exchanges for most derivative products. We must also scale down or outright prohibit certain derivative activity.

Back to credit. There needs to be a well know and estabilished way to handle credit exposure. If banks go from trading back to lending, they will do it with force and run large exposures. This must be regulated so as to limit counterparty exposure particularly amound financial institutions.

In conclusion, while i agree this could be smoke and mirrors, the proposals themselves, in concept, are not flawed. In fact, they will do the job to protect the taxpayer, but they cannot be stand alone proposals otherwise they are not implementable.

Of course the MSM has failed to point out that what was, by far, the most important thing the Massachusetts vote showed. THAT THE VOTERS STILL CONTROL WHO CALLS THE SHOTS.

Of course the question is who controls the voters? The MSM are trying very hard to. The Roberts court is certain that it’s their close friends in corporate America through the MSM. But, does anyone think the majority of voters in Mass. were getting their information from the MSM? I don’t think so. They were getting their information from the blogs.

So, keep on hammering them, Yves. You’re having a larger impact than you realized. It’s you and your co-blogers vs. the MSM for control of who calls the shots in this country. And you won in Mass. Your first of many big wins.

What is so funny is Obama trying to play the populist at the same time he is still conniving to get Helicopter Ben confirmed. As far as I can tell, the MA election through the White House for a loop. It appears to in considerable disarray. The idea that there is a problem has finally penetrated the White House bubble. The nature of it has not. The WH reaction has been to ramp up its PR machine, not understanding that people want decisive action not words. The SOTU next Wednesday is shaping up as a real disaster for this President. What progress, what accomplishments, can he point to. Healthcare is a botch, financial reform is a joke, he’s done nothing for the unemployed or homeowners. Climate change legislation is dead in the water. He’s embraced Bush’s wars and made them his own. He has bought into and expanded the worst of Bush’s legal and Constitutional excesses. He’s in a box. He can admit to failure or lie and look both dishonest and foolish. It’s lose-lose, and I only see it getting worse between now and the debacle awaiting Democrats in November.